Thursday, 18 November 2010

JOHN MANGUN
OUTSIDE THE BOX
Business Mirror
http://www.businessmirror.com.ph/home/opinion/3873-debt-and-interest-rates-how-we-win

The global financial and debt markets are in turmoil again, with Europe taking the center stage. Ireland is overextended on both its government and corporate debt, and the European Central Bank is almost demanding that Ireland draw down $100 billion to protect its debt obligation and provide liquidity for its banking sector. Portugal is in even worse shape, with debt equaling 330 percent of its gross domestic product (GDP).

Ireland is balking at taking the money as it fears losing economic sovereignty, and Europe is scared to death that investor confidence will fall even further, potentially taking down Portugal and Spain. Spain is again on the brink as car sales fell 38 percent last quarter and corporate debt amounts to 137 percent of GDP. Interest rates on both Ireland’s and Portugal’s borrowings have reached an extraordinarily high 7 percent.

The purpose of the latest Federal Reserve strategy of “quantitative easing,” or money printing, is to provide very cheap interest rates for the banks to be able to borrow from the Fed and reloan to businesses and individuals. Another purpose is to lower the value of the dollar to make US exports more attractive and foreign imports less attractive. The problem is that these two purposes are in conflict. As the dollar devalues, lenders to the US government want a higher interest rate. To offset this, the Fed will buy US government debt, thereby increasing demand for this debt and keeping interest rates low.

But the Fed cannot buy all the debt since the market is far too large. And what has happened since last week is that interest rates on US debt are actually going up, defeating the first purpose of the Fed’s action.

In summary, the financial markets are faced with an unbelievably confusing situation, particularly when talking about investing in the US and in general about the total global situation.

The US stock market is going up because the Fed is pumping new money into the economy. That’s good for both domestic and foreign investors. But all that new money is causing the dollar to go down and US inflation to go up. That’s bad for both domestic and foreign investors. Domestic investors lose purchasing power due to inflation and foreigners lose on dollar depreciation.

The Fed is buying US government debt to push interest rates lower so that banks can borrow cheaply and loan. But all the new money is causing people to worry about the value of the dollar so they are selling US government debt, causing interest rates to go up.

Europe has been able to make some slight economic gains through keeping money printing relatively stable and cutting spending. But they cannot afford to see the dollar devalue much more without devaluing the euro. This scares investors away from buying the government debt of countries like Ireland, Spain, Portugal and Italy, forcing their interest rates higher. The alternative is for the Europeans to print more money just like the Fed to bail out the bad euro debt and keep interest rates low. But then their economies will start going back down just like what is happening in the US.

Now we must also factor in the economies like Brazil that are dependent on selling to the US markets. They cannot afford to have to deal with a devalued dollar, which will harm their exports. But they cannot afford to devalue their own currencies too much because then they, too, face inflationary pressures. China runs a different risk. They will maintain their currency peg to the dollar to keep exports up but then will see the worth of their dollar holdings go down in relative value. Further, converting a substantial portion of the dollar holdings to domestic use (like they have done to an extent over the last two years) runs the risk of overheating the Chinese economy.

If you are an international money manager, perhaps at this point your head might explode trying to figure things out. Thank goodness, there is the Philippines.

Who would you rather loan money to: an 80-year-old man with a broken down house, a 20-year-old car and no job or a 40-year-old executive, rising in a large, profitable corporation, who owns a new condominium and a BMW?

That is now the accurate comparison between US government debt and Philippine government debt.

The Philippines is now a player in this global Great Game of money, politics and economics; the term Great Game once applied to the strategic rivalry and conflict between the British Empire and the Russian Empire for control of Central Asia (Afghanistan, Iran, Iraq) from 1813 until World War I. The Great Game now is between East and West, developed and emerging markets, and countries that are bankrupt and those that are not.

A historic event took place this week. The interest rate on the benchmark Philippine 91-day Treasury bills fell on Monday by 1.92 percentage points to an average 1.48 percent. This is the first time that interest rates have been below 2 percent since 1995. And even at these low rates, investors wanted 10 times as much of these bills as the government was offering. By comparison, at the latest US debt auction, the US 10-year notes rose to 2.4 percent.

Now if you are a foreign investor, do you put your money at risk in the US at 2.4 percent or in the Philippines for one year at 2.4 percent? Is there a greater chance of losing on the foreign-exchange rate for the dollar or with the peso?

Do you risk your money in the US stock market that is only being propped up by Federal Reserve “stimulus” or in the Philippines, where the companies are actually growing and making money?

The fundamentals of the Philippines are good. Inflation is low. Interest rates are stable to falling. Corporate profitability is high. The global financial climate makes the Philippines more attractive every day. The foreign money is coming in. It is just a matter of how well the country handles this cash infusion and how you profit from it

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